Invested Interest

December 17, 2001

Look who's heading the SEC

Harvey Pitt is not a household name. Until recently, the only people who regularly came across him were those in scrapes with the Securities and Exchange Commission (SEC). For such individuals, however, Pitt was the man to see. He was considered the sharpest securities lawyer in the country, and while not everybody could afford his fees, those who could were generally pleased with the results. When the SEC charged Ivan Boesky with insider trading, he hired Pitt, who engineered a lighter-then-expected sentence. Over the decades, Pitt built an impressive roster of similarly well-heeled clients who stood accused by the SEC of securities fraud, misstating their finances, other pecuniary offenses. And he has put his persuasive talents to work not just for individuals but for large economic interests who do business with the SEC--on whose behalf he has prowled the corridors of Washington as a super-lobbyist. Most of the time, Pitt fought the SEC to a draw, or better.

But in August, Pitt entered a new line of work. The bad news for those having difficulties with the SEC is that they can no longer hire Pitt to defend their interests. The good news--and, taking all things into account, it vastly outweighs the bad--is that Pitt is now chairman of the SEC. Pitt, in other words, heads the agency charged with rooting out financial crime--which is roughly the equivalent of making Johnnie Cochran head of the FBI.

To the uninitiated, it might seem strange that a Republican president would make an appointment so likely to weaken the SEC. Yes, the SEC is a government agency, which obviously militates against it from a conservative point of view. But the Commission mainly defends investors. The immediate victims of financial crimes tend to be individual stockholders. (Witness the unfortunate souls who invested in Enron.) Insider trading and fraudulent financial reporting are generally ways for those with access to privileged information to make money at the expense of those without it.

Nor are investors the only beneficiaries of an aggressive SEC. Economists across the political spectrum recognize that the market functions best when all participants have access to information. If potential stockholders fear that a firm may be padding its financial reports, they will demand a higher return--a "risk premium"--for their investment. When corporations have to offer higher returns to their investors, it costs them more money to raise capital. That makes businesses less profitable and the economy less productive. The SEC's role is to give investors confidence that they aren't going to get duped, and thereby reduce the risk premium.

So if the SEC helps investors, corporations, and the economy as a whole, why doesn't everybody love it? Because while strict regulation produces broadly shared benefits, it burdens those most directly connected with the financial industry, who have to comply with all of the SEC's rules. The various professional groups associated with Wall Street have organized to win themselves the most lenient possible treatment. Thus the appointment of Harvey Pitt.

Pitt's predecessor as chairman, Arthur Levitt, came to the SEC from Wall Street, but he used his nearly eight-year chairmanship to advance an aggressive reform agenda. Indeed, the financial press recognized Levitt's activism as a driving force in the boom market of the 1990s. Levitt's reforms, noted The Economist, "benefited Wall Street, for all its hostility to Mr. Levitt's every move, by increasing public confidence in the markets." Upon his retirement, BusinessWeek editorialized, "We won't see the likes of Arthur Levitt Jr. anytime soon."

Alas, Levitt didn't win every battle. Last year he waged a losing effort to reform corporate audits. The first line of defense against cooked books isn't--and shouldn't be--the SEC. Instead, corporations hire accounting firms to inspect their balance sheets and offer prospective investors their seal of approval. The trouble with this arrangement is that accounting firms also perform lucrative consulting work for the same companies they audit--in fact, auditing represents only around one-quarter of accounting firms' business with their clients. Obviously, this gives auditors a strong incentive to go easy. Imagine if high school teachers made most of their income selling private tutoring lessons to their students. Could they grade those students fairly in school? Of course not. (Indeed, this very system is receiving a lion's share of the blame for Enron's staggering collapse. Arthur Andersen examined Enron's books while taking in $27 million in fees for other services from the energy behemoth. Perhaps unsurprisingly, it didn't object to Enron's shady finances.)

So Levitt proposed, sensibly enough, banning accounting firms from doing other business with the same corporations they audit. The American Institute of Certified Public Accountants (AICPA) fought back with a fierce lobbying campaign that eviscerated Levitt's ban. The accountants' campaign was spearheaded, of course, by Harvey Pitt.

The fact that Pitt has spent his career thwarting the SEC does not, by itself, preclude the possibility that he could make a dramatic turnaround as chairman. But even his very short tenure to date does not inspire confidence. He set the tone a few months after taking office, in a speech to the accountants' lobby, his former client. In a barely disguised repudiation of his predecessor, Pitt announced that the SEC would no longer act "in a demeaning, demanding, or demonizing way." By contrast, the AICPA, in Pitt's telling, "has always evidenced its deep commitment to protecting the public interest." In an interview with The Washington Post, Pitt called for a "kinder, gentler" agency.

And he seems well on his way to making it so. Pitt has already replaced the top staff of the agency's critical corporate-finance division--an unusual move at the SEC, where the previous two chairmen left the staffs they inherited in place--and installed people who, like him, have a background representing the industries the SEC regulates. In October the Commission instituted an amnesty policy, whereby firms accused of violations could turn themselves in and receive little or no punishment. "I think that there have been instances where what the agency has done is focus more on an after-the-fact casting of blame and aspersion than in figuring out how to protect investors," he told the Post. "We aren't going to play gotcha." Imagine if other law enforcement agencies took this view.

Among SEC aficionados, the usual term for Pitt's ideological bent is "pro-business." But that's a misnomer--being "pro-business" at the SEC does not mean looking out for the business community as a whole. It means, rather, catering to the particular businesses that directly lobby the SEC. Their interests do not necessarily coincide with those of business generally. And they run directly counter to the interests of investors.

What makes this strange is that investors are the very group Republicans claim to represent. In recent years they have devised an entire demographic theory that you might call "The Rise of the Investor Class." Its thesis is that stock ownership has risen to the point where it now encompasses a majority of the population. This "investor class" majority supposedly has a distinct and coherent set of economic interests--as owners of capital, they identify with the rich and reject income redistribution. The White House has made references to the idea, and conservatives speak of it in almost Marxian terms, as a heroic class destined to sweep liberalism into the dustbin of history.

The investor class, as conceived by its GOP champions, is overblown. Mainly, it is an excuse for Republican politicians to claim that the interests of their K Street benefactors mirror the interests of most Americans. In truth, capital ownership remains wildly unequal--the secretary who stashes a bit of her pension in the stock market has little in common financially or politically with Bill Gates. When it comes to financial regulation, however, there really is an investor class, and it does have a coherent interest--namely, strict regulation ensuring that the information available to stockholders is accurate. Unfortunately, the K Street lobbyists who represent the financial sector have a diametrically opposed interest. The choice of an SEC chair, therefore, offers an almost perfectly designed scientific experiment to determine where the GOP's true loyalty lies. The result? Goodbye, investor class. Hello, Harvey Pitt.

This article originally ran in the December 17, 2001, issue of the magazine.